Bankruptcy Court limits franchisee’s ability to reject certain provisions in a franchise agreement

A recent decision from the United States Bankruptcy Court for the Eastern District of Michigan (the Court) held that while a franchisee could reject a franchise agreement in the bankruptcy proceeding, the non-compete clause contained in the franchise agreement remained enforceable.

In re Empower Central Michigan, Inc., 2024 WL 1848504, 73 Bankr.Ct.Dec. 127 (Bankr. E.D. Mich., April 26, 2024).  In the same decision, the Court ruled that a related confidentiality agreement could not be rejected and also remained enforceable.

The facts of the case are relatively straightforward.  Auto-Lab Franchising, LLC (Franchisor) is in the business of franchising “Auto Lab Complete Car Care Centers” throughout the Midwest. In November 2020, Franchisor and Empower Central Michigan, Inc. (Franchisee) executed a franchise agreement (the Franchisee Agreement). That same month, in order to induce Franchisor to transfer certain confidential information to Franchisee and its owner, Franchisor, Franchisee, and Franchisee’s owner executed a confidentiality agreement (the Confidentiality Agreement).

Franchisee filed for bankruptcy in August 2023 seeking to reorganize its business through a plan of reorganization. As part of its plan, Franchisee determined that it wanted to become an independent auto repair shop operating out of the same location but no longer as part of a franchise relationship. To that end, Franchisee repainted the interior space of its location, stopped reporting sales to Franchisor, posted a notice to customers that the franchise was ending and Franchisee was changing its name, and copied customer lists, all the while continuing to utilize Franchisor’s trademarks and other confidential and proprietary intellectual property. Franchisee did not contest that its actions constituted a material breach of the Franchise Agreement and the Confidentiality Agreement.

One of the benefits of the Bankruptcy Code is that it provides an opportunity for the bankrupt company to reject burdensome contracts that no longer provide a benefit to the business. However, in order for a contract to satisfy the standard for rejection under the Bankruptcy Code, such contract must be an "executory contract" – which is typically defined as a contract where “performance remains due to some extent on both sides.” When a contract is rejected, the result is that the counterparty to the contract has a claim in the bankruptcy for damages resulting from the debtor’s breach and non-performance. A claim for rejection damages is treated as a pre-bankruptcy, general unsecured claim and will receive a pro rata distribution along with all of the debtor’s unsecured creditors (i.e., unsecured claims are typically only paid pennies on the dollar). 

In February 2024, Franchise filed a motion with the Court seeking to reject the Franchise Agreement and the Confidentiality Agreement, arguing that the Franchise Agreement was no longer beneficial to Franchisee because the monthly franchise fee was its largest expense, and the Franchise Agreement provided no tangible benefit to Franchisee. Franchisor objected to the rejection motion.

In evaluating the rejection motion, the Court first had to determine whether the Franchise Agreement and the Confidentiality Agreement were “executory contracts” that could be rejected under the Bankruptcy Code.  Franchisor argued that the non-compete covenant embodied in the Franchise Agreement was non-executory and, thus, survived any rejection (regardless of the rejection of any other provisions).  Moreover, with respect to the Confidentiality Agreement, Franchisor asserted that it had completed performance of all its material obligations when it provided Franchisee with its trademarks, intellectual property, and other proprietary confidential information at the inception of the agreement. Therefore, Franchisor argued that, because there were no material continuing obligations remaining, the Confidentiality Agreement could not be considered executory and subject to rejection. The Court found that the Franchise Agreement was an executory contract and found that the Confidentiality Agreement was non-executory. 

The Court next had to determine the nature of damages arising from Franchisee’s breach of the agreements. The Court indicated that the issue of damages hinged on whether the equitable remedies contained in the agreements could be reduced to a monetary claim. Applying the Bankruptcy Code’s definition of a “claim,” the Court found that a breach that gives rise to equitable relief (e.g., injunctive relief, specific performance, etc.) depended on whether the right to equitable relief was an alternative to a right to payment under the contract. If that were the case, it would be considered a monetary claim and equitable relief would be unavailable.

After examining the provisions of the agreements, the Court concluded that the agreements intended to give rise to both monetary claims and equitable relief. The Court found that the provision concerning damages for loss of royalties under the Franchise Agreement was included to address Franchisor’s lost income stream, which was a monetary claim subject to rejection. However, the Court found that such language did not affect Franchisor’s right to obtain appropriate injunctive relief and other remedies to enforce the agreement. As such, the Court held that contract language involving Franchisor’s right to seek injunctive relief – in addition to the confidentiality and non-compete provisions contained in the agreements – was intended to protect Franchisor’s trademarks, other confidential proprietary intellectual property throughout all of its franchises, and the customer goodwill built up at Franchisee’s location over the years. Because those protections were entirely distinct from protections surrounding the stream of royalty payments, they could not be reduced to a monetary claim, and thus were not able to be rejected.

The result was that the Court granted the rejection of the Franchise Agreement but also held that, notwithstanding such rejection, the non-compete clause contained in the Franchise Agreement remained enforceable. Similarly, Court found that because the Confidentiality Agreement was non-executory it could not be rejected, and its provisions remained enforceable.

In the Empower decision, the Court balanced two competing interests: (i) relieving a franchisee of its obligations to pay future royalties on a contract that was no longer in its long-term business plan and (ii) protecting the intellectual property and other goodwill of franchisor. This ruling reveals the limits to the rejection power of the Bankruptcy Code. While a bankrupt franchisee can use bankruptcy to unburden itself of future monetary liabilities due to a franchisor, such franchisee cannot completely rid itself of those bargained-for equitable remedies that are there to protect the integrity of the brand and the confidential, proprietary information that the franchise arrangement is designed to protect.